A story on Bloomberg this morning uncharacteristically lacks a news hook but gives a good deal of color on counterparty risk in the credit default swaps market.
The story argues that the other shoe may finally drop in the $62 trillion CDS market due to rising junk bond defaults. We’ve long seen that market as a disaster in the making. With economic exposures estimated at 2% of notional amount, $1,2 trillion is at risk, making it larger than the subprime market. Thus the $150 billion in losses estimated by BNP Paribas analyst Andera Cicione is plausible.
Billionaire investor George Soros says a chain reaction of failures in the swaps market could trigger the next global financial crisis….
The market is unregulated, and there are no public records showing whether sellers have the assets to pay out if a bond defaults. This so-called counterparty risk is a ticking time bomb.
“It is a Damocles sword waiting to fall,” says Soros,…“To allow a market of that size to develop without regulatory supervision is really unacceptable,” Soros says…..
The Fed bailout of Bear Stearns on March 17 was motivated, in part, by a desire to keep that sword from falling, says Joseph Mason, a former U.S. Treasury Department economist….
“The Fed’s fear was that they didn’t adequately monitor counterparty risk in credit-default swaps — so they had no idea of where to lend nor where significant lumpy exposures may lie,” he says.
Those counterparties include none other than JPMorgan itself, the largest seller and buyer of CDSs known to the Office of the Comptroller of the Currency, or OCC.
Note that Fed only has access to regulated bank CDS exposures, but not that of investment banks or hedge funds, both of which are significant protection writers. Hedge funds, for instance, are estimated to have written 31% in CDS protection. Back to Bloomberg:
The credit-default-swap market has been untested until now because there’s been a steady decline in global default rates in high-yield debt since 2002. The default rate in January 2002, when the swap market was valued at $1.5 trillion, was 10.7 percent, according to Moody’s Investors Service.
Since then, defaults globally have dropped to 1.5 percent, as of March. The rating companies say the tide is turning on defaults.
Fitch Ratings reported in July 2007 that 40 percent of CDS protection sold worldwide is on companies or securities that are rated below investment grade, up from 8 percent in 2002….
A surge in corporate defaults may leave swap buyers scrambling, many unsuccessfully, to collect hundreds of billions of dollars from their counterparties, says Satyajit Das, a former Citigroup derivatives trader….
“This is going to complicate the financial crisis,” Das says. He expects numerous disputes and lawsuits, as protection buyers battle sellers over the technical definition of default – - this requires proving which bond or loan holders weren’t paid — and the amount of payments due.
“It’s going to become extremely messy,” he says. “I’m really scared this is going to freeze up the financial system.”
Andrea Cicione, a London-based senior credit strategist at BNP Paribas SA, has researched counterparty risk and says it’s only a matter of time before the sword begins falling. He says the crisis will likely start with hedge funds that will be unable to pay banks for contracts tied to at least $35 billion in defaults.
“That’s a very conservative estimate,” he says, adding that his study finds that losses resulting from hedge funds that can’t pay their counterparties for defaults could exceed $150 billion…..
Cicione says banks will try to pre-empt this default disaster by demanding hedge funds put up more collateral for potential losses. That may not work, he says. Many of the funds won’t have the cash to meet the banks’ requests, he says.
Sellers of protection aren’t required by law to set aside reserves in the CDS market. While banks ask protection sellers to put up some money when making the trade, there are no industry standards, Cicione says…..
“I think there’s a major risk of counterparty default from hedge funds,” Cicione says. “It’s inconceivable that the Fed or any central bank will bail out the hedge funds. If you have a systemic crisis in the hedge fund industry, then of course their banks will take the hit.”
The Joint Forum of the Basel Committee on Banking Supervision, an international group of banking, insurance and securities regulators, wrote in April that the trillions of dollars in swaps traded by hedge funds pose a threat to financial markets around the world.
“It is difficult to develop a clear picture of which institutions are the ultimate holders of some of the credit risk transferred,” the report said. “It can be difficult even to quantify the amount of risk that has been transferred.”
Counterparty risk can become complicated in a hurry, Das says. In a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle, Das says….
“It creates a huge concentration of risk,” Das says. “The risk keeps spinning around and around in this daisy chain like a vortex. There are only six to 10 dealers who sit in the middle of all this. I don’t think the regulators have the information that they need to work that out.”
And traders, even the banks that serve as dealers, don’t always know exactly what is covered by a credit-default-swap contract. There are numerous types of CDSs, some far more complex than others.
More than half of all CDSs cover indexes of companies and debt securities, such as asset-backed securities, the Basel committee says. The rest include coverage of a single company’s debt or collateralized debt obligations…
Banks send hedge funds, insurance companies and other institutional investors e-mails throughout the day with bid and offer prices, [hedge fund advisor Tim] Backshall says. For many investors, this system is a headache.
To find the price of a swap on Ford Motor Co. debt, for example, even sophisticated investors might have to search through all of their daily e-mails, he says.
“It’s terribly primitive,” Backshall says. “The only way you and I could get a level of prices is searching for Ford in our inbox. This is no joke.”
In the past three years, at least two companies have developed software programs that automatically parse an investor’s incoming messages, yank out CDS prices and build them into real-time price displays.
The charts show the highest bids and lowest offering prices for hundreds of swaps. Backshall tracks prices he gets from banks using the new software….
BNP analyst Cicione says regulators will be hard-pressed to prevent the next potential breakdown in the swaps market.
“Apart from JPMorgan, there aren’t many other banks out there capable of doing this,” he says. “That’s what’s worrying us. If there were to be more Bear Stearnses, who would step in and give a helping hand? You can’t expect the Fed to run a broker, so someone has to take on assets and obligations.”
Banks have a vested interest in keeping the swaps market opaque, says Das, the former Citigroup banker. As dealers, the banks see a high volume of transactions, giving them an edge over other buyers and sellers.
“Dealers get higher profitability through lack of transparency,” Das says. “Since customers don’t necessarily know where the market is, you can charge them much wider margins.”
Banks try to balance the protection they’ve sold with credit-default swaps they purchase from others, either on the same companies or indexes. They can also create synthetic CDOs, which are packages of credit-default swaps the banks sell to investors to get themselves protection.
The idea for the banks is to make a profit on each trade and avoid taking on the swap’s risk.
“Dealers are just like bookies,” Kane says. “Bookies don’t want to bet on games. Bookies just want to balance their books. That’s why they’re called bookies.”….
Arturo Cifuentes, managing director of R.W. Pressprich & Co., a New York firm that trades derivatives, says he expects a rash of counterparty failures resulting in losses and lawsuits.
“There’s a high probability that many people who bought swap protection will wind up in court trying to get their payouts,” he says. “If things are collapsing left and right, people will use any trick they can.”
Frank Partnoy, a former derivatives trader and now a securities law professor at the University of San Diego School of Law, says it’s high time for the market to let in some sunshine.
“There should be a centralized pricing service for credit-default swaps,” he says. Companies should disclose their swaps holdings, he adds.
“For example, a bank might disclose the nature of its lending exposure based on its use of credit-default swaps as a hedge,” he says.
Last year, the Chicago Mercantile Exchange set up a federally regulated, exchange-based market to trade CDSs. So far, it hasn’t worked. It’s been boycotted by banks, which prefer to continue their trading privately.
Leo Melamed, 76, chairman emeritus of Chicago Mercantile Exchange Holdings Inc., says there aren’t any easy solutions.
“Plus we’re not sure the banks want us to be in this business because they do make a good deal of money, and we might narrow the spreads considerably,” he says.